Look! Up in the Sky! It's An Inflation-Fighting Fed!

July 7, 2006 7:43 AM by Mises.org Updates (Archive)

How can we "fight" inflation, asks Cyd Malone, if we pretend not to have even a clear idea of its cause? For example: Bernanke blames oil for inflation ("a significant increase in energy prices can simultaneously slow economic growth while raising inflation") in direct contradiction to Bernanke ("the main reason for high inflation rates is the rapid rates of money growth"). So it is clear that when it comes to the subject of inflation we're all in a serious intellectual slump. Also: a contest for worst Fed governor ever. FULL ARTICLE

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Comments (84)

Stephen W. Carson

I have submitted this to Digg. Please digg it!

Published: July 7, 2006 7:58 AM
David

'I can't save a cent
It takes all of my money
I got the blues
Got those inflation blues

– B.B. King'

funny you should quote BB King. Arguably the hardest-working touring musician in history, he spent decades with an IRS employee as a full-time member of his touring entourage, courtesy of a tax'n'penalty hole dug so deep that he spent most of his life working to pay it off - and the IRS made damn sure they were there to cream off the lion's share.

Published: July 7, 2006 8:29 AM
PR

One minor quibble. It's probably a better to compare the Fed chairmen by CPI increase per year rather than over their entire term. I was curious so I did this in a spreadsheet:

Charles S. Hamlin, 4.26%
W. P. G. Harding, 7.44%
Daniel R. Crissinger, 0.47%
Roy A. Young, -1.37%
Eugene Meyer, -8.84%
Eugene R. Black
Mariner S. Eccles, 4.42%
Thomas B. McCabe, 2.59%
Wm. McC. Martin, 2.17%
Arthur F. Burns, 6.67%
G. William Miller
Paul A. Volcker, 5.74%
Alan Greenspan, 3.10%

I used the formula
100 * ((1/cpi_ratio) ^ (12/months_in_office) - 1)
where cpi_ratio refers to column 3 in the table used in the article.

Published: July 7, 2006 9:45 AM
Roger M

Excellent depiction of inflation! It seems that most people in finance blaim the Great Depression on deflation, and so are petrified of it. Mild inflation, in their minds, puts a buffer zone between us and the sheer horror of deflation. But as Malone writes, productivity increases would cause prices to fall naturally, given a stable currency. Mild inflation encourages consumer spending and debt, which of course is what Keynes wanted. If the Fed would adopt a policy of mild deflation, we would create a society in which people valued savings more than debt. Banks would have less power of the economy. Social Security would disappear, because it would be too easy for people to save enough for their old age. The poor would grow richer because under mild inflation, their wages never keep up with price increases, while under deflation, they would grow richer each year even if they never got another raise. It could issue in a golden age!

Published: July 7, 2006 9:55 AM
Reformed Republican

Thanks PR. I too thought the chart would be better done with inflation normalized to time in office. I just had not had a chance to do it. It definitely changes the winners and losers a bit.

I would also like to see a comparison to the rate of inflation before the era of the Fed.

Published: July 7, 2006 10:00 AM
M E Hoffer

RR, et al. ,

Try: http://www.minneapolisfed.org/Research/data/us/calc/hist1800.cfm

Published: July 7, 2006 10:13 AM
Thant Tessman

I too considered that it might be more relevant to consider the CPI increase per year, but remember, the comparison is with the claim that they are there to achieve price stability. Surely the more time you have, the easier the task.

Published: July 7, 2006 10:22 AM
David Spellman

The machinery of the Federal Reserve is a grotesque evil by itself, but far worse is the lying done to cover it up. Given that the Federal Reserve operates legally, I am compelled to accept it at the moment even though I don't like it. But I have no confidence whatsoever in the people operating it given that they know full-well what the deal is and prevaricate constantly about what is going on. We should be most alarmed about dishonest men and women ruling over us no matter what system that rule is framed in.

Like the Bible says, "When the wicked rule, the people mourn." We should be in sack cloth and ashes. Come to think of it, our economy is pretty much in ashes already, we just need for Paris and New York to bring gunny sacks into style.

Published: July 7, 2006 10:30 AM
Stephen W. Carson

This story has been promoted on Digg. The discussion is getting going over there, so go and join in. For goodness sake, please be intelligent and civil... When people have forgotten the argument you made they will remember whether you were thoughtful and respectful (or rude and arrogant).

Published: July 7, 2006 10:34 AM
PR

In addition to the link M E Hoffer provided, here's a nice graph that I think was mentioned on mises or lewrockwell some time ago. I printed it out and have it hanging over my desk. It makes the notion that the Fed "fights inflation" downright laughable:

http://www.mrderrick.com/blog/?p=30

Published: July 7, 2006 10:36 AM
Bill

Excellent essay! In all fairness what was the Fed to do? Essentially they gave us what we wanted and ENJOYED. While the intrensic wealth of our country was be exported and depleted the average moronic Amereican fought to remain in a state of bliss: The Fed amortized our diminishing wealth over more and more dollars as a implement of appeasement: So the average American waits for the return of two a gallon gasoline while the internatiolnal investors are sure to become less interested with US dollars. What is to come? The answer has been revealed per one of Mr Rockwell's recent writings.

Published: July 7, 2006 11:20 AM
Nathan Reed

An observation. Perhaps the reason the general public is confused about inflation is because these discussion keep using prices to discuss inflation (we get plenty of this on CNBC). I completely agree with the points in the article but question the use of CPI for any discussion of inflation. CPI is some twisted attempt to gauge prices. Prices can change for many reasons and can significantly increase or decrease in opposition to inflation. If we want to indicate a level of increase in prices we should say "prices are going up and we belive it significantly results from an inflation of the supply of money". By the way. Good luck correlating the two.

Now we are making historical charts of questionable CPI figures to discuss inflation and wondering why folks are ignorant and confused.

It seems some rigor is in order. First they move the definition of inflation from money supply to prices. Then they convince folks that CPI is a accurate measure of prices (inflation). Now all thats left is to fiddle with the CPI to finish off the lie. I think this is how my aquaintences of left leanings came to call themselves liberal. I relentlessly observe to the point of irritation that I am liberal and they will have to go find their own banner. Just a thought.

Just a thought.

Published: July 7, 2006 11:43 AM
Mike Sproul

"While many talk about the effects of inflation, none talk about the possibility that any group of men given the power to COUNTEREIT MONEY OUT OF THIN AIR would maybe, just maybe, be even a little bit tempted to abuse such power."

The Fed is not a counterfeiter. The Fed issues every new dollar in exchange for a dollar's worth of bonds; a counterfeiter prints the dollars and spends them. The Fed recognizes its dollars as it liability and puts its name on them; a counterfeiter does neither. If the Fed sees the value of its dollars falling, it sells its bonds and retires the dollars obtained; a counterfeiter does not.
For an explanation of inflation that avoids quantity theory and Keynesian fallacies, try reading
www.geocities.com/sproulmike/nofiatmoney.doc

Published: July 7, 2006 12:09 PM
billwald

Why does the stock market rise when there is bad news for the working class? Because there are two economies - for the working class and for the coupon clipping class. It is very difficult to rise from the working class to the clipping class. Why, then, do Libertarians worry about the economy of the clipping class?

Deflation helps the clipping class because their coupons buy more goods. Low Inflation helps the working class because ther pay their mortgages with cheaper money.

Libertarians work as hard as they can for policies which will transfer assets from the working class to the clipping class, thinking they will become coupon clippers. Fat Chance of that!

One reason Libertarians think they can become rich people is that they fail to differentiate between the new rich and the old money. The Old Money people are the ones who control the Swiss banks and whatever. We don't know who they are. Nothing has hurt the old money since the French Revolution.

Lists of rich people are the new rich. They mostly own paper assets. If they tried to convert their paper assets to land and useful stuff the market would collapse.

One Libertarian myth is that personal savings are somehow used to increase productivity which ultimately benefits the working class. This might have been true under the old system that used hard money but is not true under electronic money. Only the sales of initial offerings goes to the companies and what percentage of the market it that? The rest goes to run up the paper profits of the coupon clippers.

Published: July 7, 2006 12:16 PM
Roger M

Mike: "The Fed issues every new dollar in exchange for a dollar's worth of bonds..."

Whatever the Fed is doing, it's destroying the value of our money. Just check their own price indexes.

Published: July 7, 2006 12:30 PM
M E Hoffer

billwald makes an interesting, and little noticed, point: "The "old money" never shows up on lists like the Forbes 400."

The canard that W. Buffett is the world's second wealthiest man is rich, indeed.

More people should take the opportunity to attend a Presidential Inauguration, to have a look around.

Published: July 7, 2006 12:55 PM
Roger M

Billwald's post is so full of errors it's hard to know where to start.

"Deflation helps the clipping class because their coupons buy more goods. Low Inflation helps the working class because ther pay their mortgages with cheaper money."

Deflation would increase savings a reduce demand for loans. It would increase savings because, in addition to the interest payments, the value of the dollar would grow by the rate of deflation. With greater savings and less borrowing, interest rates would fall, thus hurting coupon clippers.

"Deflation helps the clipping class because their coupons buy more goods." True but it helps the poor just as well.

"Low Inflation helps the working class because ther pay their mortgages with cheaper money." This is true only if the inflation is a surprise; if banks expect it, they build inflation into the loan amount so the working class gets no benefit. Besides, wouldn't the working class benefit more from a currency that grows in value? Income is far more important to the working class than getting a break on loans.

"...fail to differentiate between the new rich and the old money." The "old money" isn't included because they aren't rich any more. The turnover in wealth in the US is amazing. The old rich become the new middle class, or poor, and vice versa every year. Just read any book by Dr. Thomas Stanley, who's latest was "The Millionaire Next Door." If the old rich are so powerful, why aren't they rich?

Published: July 7, 2006 1:17 PM
mvpy

"Yet at the same time the same people who are cheering rising productivity are explicitly calling for a monetary policy to "maintain a stable price level" — a policy that, should it succeed to perfection, would destroy the very gains that rising productivity gives to the working masses."

Wait a second. Suppose Im producing 5 coconuts on an island and theyre 1 dollar each. Now, productivity increases, and I can produce 10. To keep the price level from falling to .5, the FED doubles the money supply. So, now I have 10 coconuts priced at 1 dollar (as opposed to 5 at 1 dollar before).
I cant see any fall in the standard of living at all; rather, it has doubled.

Also, I think *sustained* inflation is always and everywhere a monetary phenomenon. Supose half the economy is oil related; the other half isnt. Then OPEC doubles the price of oil, prompting the oil dependent part of the economy to double their prices. Thats an increase in inflation. However, the fall in purchasing power will induce a recession, whichll cause inflation to fall again. Point is, oil hikes can cause inflation to rise, but not permanently; we need sustained increases in money growth for that.

Anyway, really liked the article. Its a pity more economists dont write as well.

Published: July 7, 2006 1:24 PM
George Giles

Giving the Fed credit for fighting inflation is like giving the Burgular credit whom having broken into your home breaks your leg with a sledge hammer, hands you a crutch and then expects gratitude for the fine crutch he has provided.

Read William Sumner Graham "Ths History of Banking in the Leading Nations" - this story (inlfation, the unlegislated tax) is as old as dirt.

Published: July 7, 2006 1:54 PM
Ohhh Henry

Not that the good people of the Federal Reserve like inflation. Their stated mission is to "maintain stable prices", stable being defined by Webster's as "not changing or fluctuating."

Yes, but their unstated mission is to help politicians win elections by providing a constant source of money in order to buy votes and to create the illusion that the State is the source of all wealth and prosperity.

Published: July 7, 2006 2:13 PM
Nathan Reed

Sorry to bother but can someone explain how OPEC can cause inflation by changing prices. If I discover a trillion barrel reserve of light sweet crude 2 feet underground on my property I bet the price of oil will go down tomorrow. Did I just eliminate some money from the system?

First of all OPEC does not set prices. The market does. Secondly I cannot see how a market change in oil prices can cause a change in the supply of money (inflation). Am I confused.

Published: July 7, 2006 2:32 PM
Paul Edwards

Mike,

"The Fed is not a counterfeiter. The Fed issues every new dollar in exchange for a dollar's worth of bonds; a counterfeiter prints the dollars and spends them.�?

I presume what you are saying is that the members of the FOMC don't go out and buy themselves homes and cars and yachts with the new reserves they create. This is true. However, it is not strictly the criterion for the definition of counterfeiting.

Counterfeiting is simply creating false claims against goods that don't exist. This they certainly do. That they can theoretically undo their counterfeiting doesn't change its nature. The fact that over the long term, they never do anything but buy and never sell their bonds, on net gives a hint as to their true intentions.

The practical results are the following: there are more reserves available on which the banking industry can permanently expand credit in the economy. That is, the banking industry can also further counterfeit claims to money based on this inflation of bank reserves produced by the fed.

All interest and profits earned based on this activity is fraudulently obtained and it is all based on the fact that these reserves and the credit expansion is based on counterfeit claims to money.

Published: July 7, 2006 2:38 PM
Paul Edwards

Nathan,

You're not confused. You are correct. Inflation is purely a monetary thing.

What you are correctly driving at is the following: An increase in the demand for oil will tend to result in an increase in its price. It will also tend to result in a decrease in demand and price for its substitutes. There is no inflation and no net price increases implied in this situation, all other things remaining the same.

Similarly, a decrease in the supply of oil will result, presuming a very inelastic demand for it, in an increase in price and an overall increase in the amount spent on oil, and a concomitant overall decrease in the amount spent on its substitutes. Again, as you suggest, this implies no general increase in prices. If the demand for oil were to be elastic, then although its price would still increase, overall, the amount spent on oil would decrease and the amount spent on its substitutes would increase. Again, no with no attendant price inflation.

Published: July 7, 2006 2:57 PM
Paul Edwards

Mvpy,

“Wait a second. Suppose Im producing 5 coconuts on an island and theyre 1 dollar each. Now, productivity increases, and I can produce 10. To keep the price level from falling to .5, the FED doubles the money supply. So, now I have 10 coconuts priced at 1 dollar (as opposed to 5 at 1 dollar before).

“I cant see any fall in the standard of living at all; rather, it has doubled.�?

You have neglected to consider the effect of the wealth redistribution and investment dislocations implied throughout the process of this inflation. The doubling of the money supply never occurs by a simple doubling of the money in everyone’s pocket or a doubling of everyone’s wages, or a doubling of every single commodity’s price. Inflation via credit expansion leads to wealth being transferred to borrowers and lenders of the new money and away from those who receive it much later. It leads to wasteful investments in higher order stages of production that are not merited based on people’s true time preferences. It therefore leads to consumption of capital, and a necessary longer term reduction in productivity compared to what would have existed without the expansion. In the end, the economy has suffered from a wasting of capital resources, is less productive, and is in a poorer position to satisfy the wants of the consumer.

While you may be still producing 10 coconuts instead of 5, someone else has wasted resources on producing graffle grommets, when they perhaps should have been investing in a new stall in their store to sell your coconuts.

Published: July 7, 2006 4:27 PM
Mike Sproul

Paul:
"Counterfeiting is simply creating false claims against goods that don't exist. This they certainly do. That they can theoretically undo their counterfeiting doesn't change its nature. The fact that over the long term, they never do anything but buy and never sell their bonds, on net gives a hint as to their true intentions.

The practical results are the following: there are more reserves available on which the banking industry can permanently expand credit in the economy. That is, the banking industry can also further counterfeit claims to money based on this inflation of bank reserves produced by the fed. "

Suppose some new foreign money is introduced, and it is so much more convenient than paper dollars that nobody wants to hold paper dollars anymore. Paper dollars will pile up in bank vaults, the overnite rate will fall, and there will be downward pressure on the value of the dollar. The Fed can (and probably will) respond by selling its bonds for dollars and retiring the dollars received. (Like it does after the xmas shopping season) There is no reason this could not continue until the last paper dollar is retired and we're all using the foreign money exclusively. This would not happen with a counterfeiter. The counterfeit money would simply lose all its value. This is a very clear distinction between what the Fed does and what a counterfeiter does.
The Fed does not issue money without getting adequate security in exchange, and neither do private banks, so neither paper dollars nor checking account dollars are issued against "goods that don't exist".
The difference between banks (public and private) and counterfeiters is so obvious that it seems ridiculous to take any pains to prove it. Austrians make a huge mistake when they deny the difference.

Published: July 7, 2006 5:06 PM
Clyde W

I recommend that we do as Henry Hazlitt did when writing about inflation. Given inflation’s change in meaning he said that there are two inflations; one is money (I prefer dollar) inflation and the other price inflation.

By doing this we can be clear what we mean by inflation. In addition, we can state that dollar inflation leads to price inflation. No more just inflation.

Clyde W.

Published: July 7, 2006 5:32 PM
mvpy

Paul:
Thank you for the insights - I hadnt considered these distortions, I was using money neutrality as my benchmark. Ill have to do some readings, but thanks again

Published: July 7, 2006 11:32 PM
Cyd Malone

I thank you all for your comments, both pro and con. If nothing else, the comment about Fed gov Poole cracked me up.

Published: July 8, 2006 12:01 AM
adi

Demand for money can be explained by the services which it offers to its holders and by legal restrictions ( usually you must pay taxes in local currency and appreciation of some alternative asset you hold is subject to a capital gains taxation )

Fiat currency is not backed by anything and its ridiculous to claim that people hold money because govt may someday use tax revenues to buy back securities it has itself created when it can actually print more money.

Mr Sprouls theory is actually just as fallacious as real bills doctrine since increases in the prices of commodities ( caused by printing money )used as a collateral will then increase money in the circulation since banks can now create more money ( as nominal value of collateral is increasing ).

Published: July 8, 2006 2:07 AM
Thant Tessman

"Demand for money can be explained by the services which it offers to its holders and by legal restrictions ( usually you must pay taxes in local currency and appreciation of some alternative asset you hold is subject to a capital gains taxation )"

More than that, there is one very important commodity that can only be purchased with dollars: oil. And a whole lot of the U.S. government's foreign policy can be explained as an attempt to keep things that way.

http://www.indymedia.org.uk/en/2006/06/342746.html

Published: July 8, 2006 9:10 AM
Mike Sproul

adi:

Funny you should say my theory is just as fallacious as the real bills doctrine, since my theory IS the real bills doctrine.

"increases in the prices of commodities ( caused by printing money )used as a collateral will then increase money in the circulation since banks can now create more money"

You are assuming what you're trying to prove. On real bills principles, an increase in the quantity of money (accompanied by an increase in backing) will not cause inflation, and the self-perpetuating cycle of more money and more inflation that you describe will never get started. Only by assuming the correctness of the quantity theory at the start (i.e., saying that an increase in the money supply causes inflation) do you conclude that the RBD is false.

I have a paper on this entitled "Three False Critiques of the Real Bills Doctrine" which is easy to find with a google search. You could also google "real bills doctrine" to find several papers I've written on the subject.

The idea that fiat money is not backed by anything leads to a rat's nest of contradictions and fallacies. The correct explanation is that there's no such thing as fiat money.

Published: July 8, 2006 11:03 AM
Thant Tessman

adi: "increases in the prices of commodities ( caused by printing money )used as a collateral will then increase money in the circulation since banks can now create more money"

Mike Sproul: "You are assuming what you're trying to prove."

No he's not. He's making a purely factual statement about the nature of fractional-reserve banking.

Published: July 8, 2006 11:10 AM
Thant Tessman

And here's an excellent example from history illustrating how governments impose the use of fiat currency:

http://www.kitco.com/ind/saville/jun202006.html

Published: July 8, 2006 12:07 PM
M E Hoffer

Thant,

Yes. Quite so. That is a fine article that should drive home the salient point(s) re: Fiat currency and taxation as demand stimulator for same.

The Federal Reserve would not be nearly so profitable lacking the State's "Legal Tender" laws and its demand for FRN in the payment of Taxes.

Published: July 8, 2006 12:33 PM
adi

I do not understand Mr Sprouls argument that creation of more deposits by banks if someone brings IOU's to them will not cause inflation.

Suppose we have pure credit economy where banks can freely create demand deposits if there is collateral. Then merchant brings IOU's to bank and bank discounts them by using proper bank rate and says to merchant: " You have now amount of X currency in your deposit account in our bank "

Problem is of course ( noticed by Knut Wicksell of Stockholm School ) that if bank rate is wrong ( lower than the "natural rate" ) so that merchant can make arbitrary large amount of profit by loaning from the bank , then price level is indetermined in real bills regime. Contraction and expansion can be very large and variable. Merchant can probably always bring sufficient collateral since streams of revenues from the prospective investments are discounted by the bank rate and then also value of collateral is greater.

Published: July 9, 2006 2:58 AM
Peter

I do not understand Mr Sprouls argument that creation of more deposits by banks if someone brings IOU's to them will not cause inflation.

Be thankful that you don't. I'm sure understanding crackpot claims can't be good for you.

Published: July 9, 2006 5:36 AM
Mike Sproul

adi:

"I do not understand Mr Sprouls argument that creation of more deposits by banks if someone brings IOU's to them will not cause inflation."

The real bills view is that the issue of money works just like the issue of corporate stock. Everyone agrees, for example, that if GM stock is currently worth $60 per share, then GM can print a new share, sell it for $60 cash, and there will be no effect on GM's share price because GM's assets have risen in step with its liabilities. Wicksell's argument would apply to stock as much as it applies to money--which is to say, not very much. For example, GM could issue its new share for a bond that carries a "wrong" interest rate--too low and GM stock will fall, too high and GM stock will rise, but on average, these errors will cancel out and GM stock will be unaffected.

The real bills view is easiest to understand from the T-account below.

ASSETS...................LIABILITIES
100 oz. silver...........$100 paper
IOU worth $200...........$200 paper lent

In line 1, the bank accepts 100 oz. of silver on deposit and issues 100 paper receipts ("dollars") in exchange. A farmer then requests a loan of $200, offering his farm (worth maybe $400) as collateral. The new dollars are adequately backed by the IOU, which is in turn backed by the farm, so the value of the dollar stays at 1 oz.

The Austrian view is that the action in line 2 is fraudulent and should be prohibited, since the IOU is not actual silver, but only something (currently) worth 1 oz. of silver.

Fuller explanation at:

www.geocities.com/sproulmike/nofiatmoney.doc

Published: July 9, 2006 12:13 PM
Thant Tessman

Mike Sproul: "The Austrian view is that the action in line 2 is fraudulent and should be prohibited, since the IOU is not actual silver, but only something (currently) worth 1 oz. of silver."

Not quite. The Austrian view is that the "paper lent" would trade at a discount determined by the risk and inconvenience associated with redeeming the paper for specie, which is exactly what happened back when these things were called "shares."

Published: July 9, 2006 2:24 PM
Thant Tessman

Just to be clear, the "fraud" is in the obfuscation of the difference between a demand deposit and a timed deposit. That, and the fact that the government has long since absolved the banks of their legal responsibility to redeem bank notes in specie.

Published: July 9, 2006 2:35 PM
Paul Edwards

Mvpy,

My pleasure.

Clyde,

“I recommend that we do as Henry Hazlitt did when writing about inflation. Given inflation’s change in meaning he said that there are two inflations; one is money (I prefer dollar) inflation and the other price inflation.

“By doing this we can be clear what we mean by inflation. In addition, we can state that dollar inflation leads to price inflation. No more just inflation.�?

I agree with you when talking to those not exposed to Austrian theory. However, when the audience is mises.org, I think it is almost universally understood that inflation is the monetary type, and only price inflation, the symptom of inflation, requires the “price�? adjective.

I think the same even applies to the term “liberal�? on this site. Here it is of the Misesian “classical�? meaning. Outside, one must specify, or just resort to another term altogether.

Published: July 9, 2006 5:40 PM
Paul Edwards

Mike,

The first fundamental flaw with the T-account representation of a deposit of 100oz of silver is that it is misrepresented as a loan to the bank. It is in fact a deposit or a bailment; not a loan. If this single fundamental fact were to properly considered, one would realize that this silver does not even belong on the T-account of the bank because the possession of this silver is neither an asset, nor is it “owed�? to the depositor in the way that a liability type loan would be.

The easiest way to fathom this fact is to imagine if you put your car or expensive paintings in storage, would you expect these things to turn up on the storage company’s assets and liabilities sheets? No, it stores these things and they remain the client’s possession and fully and immediately owned by them at all time.

But let’s overlook this massive financial misrepresentation of the facts of the situation and analyze it further. Firstly, when you list an asset of 100 oz silver, you also have a liability of 100 OZ SILVER. Not something else named mystically "dollars". This is the second deceptive slight of hand. The situation is more honestly depicted rather than this:

“ASSETS...................LIABILITIES
�?100 oz. silver...........$100 paper

more accurately it is:

“ASSETS...................LIABILITIES
�?100 oz. silver...........demand claim (paper receipt) for 100 oz silver

This more explicit representation shows more clearly how the FR loan is fraudulent. Rather than this:

�?IOU worth $200...........$200 paper lent�?

It should be this:

IOU of 200 oz silver........... demand claim (paper receipt) for 200 oz silver

From this it is clear that the bank has issued demand claims to silver that it cannot have a hope in heck of ever redeeming should all clients decide to exercise their right to redeem. The fact that the IOU is a loan with a farm as collateral is not relevant to the fraud carried out. The bank has issued receipts in excess of the specie they posses.

“In line 1, the bank accepts 100 oz. of silver on deposit and issues 100 paper receipts ("dollars") in exchange.�?

The bank issues paper receipts for 100 silver ounces.

“A farmer then requests a loan of $200, offering his farm (worth maybe $400) as collateral.�?

The farmer then requests a loan of 200 silver ounces, offering his farm … as collateral.

“The new dollars are adequately backed by the IOU, which is in turn backed by the farm, so the value of the dollar stays at 1 oz.�?

The new receipts of silver are fraudulent because there is not enough silver available with the bank nor was there ever, to be redeemed by those holding the honest and also fraudulent silver warehouse receipts.

“The Austrian view is that the action in line 2 is fraudulent and should be prohibited, since the IOU is not actual silver, but only something (currently) worth 1 oz. of silver.�?

It is fraudulent because these warehouse receipts to silver are redeemable in silver and there is no silver in the bank’s possession with which to redeem all these claims. The collateral is not relevant to the discussion of the economic analysis of false money creation.

Published: July 9, 2006 6:13 PM
Al

I just got this comment from a good friend on my blog, in response to posting some exerpts of this article:
The reason the Fed attempts to control inflation is not to keep inflation from happening at all but to keep it from happening so fast that it causes economic damage to the general populace. Part of the trouble we used to have in our economy (19th and early 20th centuries) is that an unregulated system can, on occasion, begin to oscillate wildly. That is not a good condition for a nation’s fiscal health. The regulation we've added is just there to dampen the cycle so it won't get away from us. Our economic world is too large and complex to not do this.

The people who tend to buck at this sort of activity are the ones who don’t like the idea of government at all.

Published: July 9, 2006 9:17 PM
Mike Sproul

Thant Tessman:

"Just to be clear, the "fraud" is in the obfuscation of the difference between a demand deposit and a timed deposit."

Would you still call it fraud if the bank's customers understand what the bank's assets are and agree to the arrangement? They would just be recognizing the risk that some day the bank might not be able to redeem all 300 notes in silver, so instead they'll have to settle for whatever assets the bank has--namely, the farmer's IOU, backed by the farm. As long as both parties to the trade agree to it, why would a good libertarian object?

"That, and the fact that the government has long since absolved the banks of their legal responsibility to redeem bank notes in specie."

See the link I referenced above for a discussion of physical covnertibility vs. financial convertibility.

Published: July 9, 2006 10:07 PM
Mike Sproul

Paul:

Your objections can all be overcome by the simple act of the customers agreeing to what the bank is doing. All customers recognize that even a 100% reserve bank can be robbed, and their notes will then be worthless, so rational customers should not be particularly leery of a bank that diversifies its assets. The bank can still pay one ounce for one note in normal times, but have a clause that allows them to suspend convertibility in bad times. Banks have often done this and customers have often agreed to it, and when they both agree, there is no fraud.

Published: July 9, 2006 10:18 PM
Paul Edwards

Mike,

“Your objections can all be overcome by the simple act of the customers agreeing to what the bank is doing.�?

I think it was Hoppe who pointed out that knowingly handing over one’s assets to a bank, only to have duplicate claims to them issued to other borrowers, in a free market, amounts to participating in a lottery on recovering one’s own property. I think it is possible that some people are foolish enough to gamble in this way, however, I think the majority must truly be bamboozled into such a foolish position. And that would be fraud.

However even if, for sake of argument, we allow that the depositors are aware of the shell game and up for the risk of loosing their money in a foolish gamble, there is still fraud. This is because the borrowers will fraudulently pass their borrowed counterfeit warehouse receipts on to necessarily unsuspecting traders, who are expecting to be paid with real money, not with fraudulent duplicate receipts to other people’s money.

To the extent that these trading partners accept the money substitutes, they will believe they are accepting honest claims to actual money and they are therefore being defrauded. To the extent that they realize they are being offered counterfeit duplicate claims to someone else’s money, they will not accept them at all, or else they will hope to pass these receipts on and defraud someone else before the fraud is discovered.

Published: July 9, 2006 11:03 PM
Manuel Lora

Paul says:

To the extent that these trading partners accept the money substitutes, they will believe they are accepting honest claims to actual money and they are therefore being defrauded. To the extent that they realize they are being offered counterfeit duplicate claims to someone else’s money, they will not accept them at all, or else they will hope to pass these receipts on and defraud someone else before the fraud is discovered.

Let's say A gives those money substitutes to B and at this point the bank has gone fractional. A does not yet know this. Would A be guilty of defrauding B? I don't think so. My guess is that B would have to deal with the bank now, and not A at all.

Published: July 9, 2006 11:21 PM
Paul Edwards

Al,

“The reason the Fed attempts to control inflation is not to keep inflation from happening at all but to keep it from happening so fast that it causes economic damage to the general populace.�?

The fed and the banking industry are the sole sources of all monetary inflation, which is to say all inflation. If our economy was put back on a gold coin standard, and the fed halted its activities and died, and the banks were to desist in FR banking, all inflation, bank runs and business cycles would be a thing of the past.

The fed is the culmination of the banker’s magnificent con job. They deserve a lot of credit for their craftiness and cunning, but certainly none for their non-existent honesty or integrity. The people have been duped and they have been duped in a most breath-taking manner. It is the banker’s and the government’s lie that the fed is in place to benefit the general populace. It is put in place to benefit the bankers and the government to the detriment of the market and the general public.

For a pretty good elaboration on banking and money look for Rothbard’s articles on the topic.

Published: July 9, 2006 11:33 PM
Paul Edwards

Hi Manuel,

"A does not yet know this."

Is the answer to your question; you are right that he could not be a participant in fraud. As far as he knows and as far as he can be expected to know, A is handing clear title to his money over to B. Both A and B have been defrauded by the bank.

However, to clarify, my scenario was in response to the hypothetical situation where the bank customers were aware of the bank’s fraudulent issue of counterfeit receipts, and the assertion that this awareness would eliminate the fraud. My answer is that customers can become complicit in the fraud, but fraud must still remain at the foundation of the activity. And this is because, at the root, people who receive the receipts must believe they are receiving true titles to money, and not counterfeit titles. It turns out that in a free market, receivers of counterfeit claims to money must either be victims of fraud, or else they are complicit in fraud. There’s no third alternative. Of course, what we have today is institutionalized fraud legislated by the aggressive state. Few have a choice but to go along.

Published: July 9, 2006 11:51 PM
TGGP

Here's a short Gene Callahan piece on the legitimacy of fractional reserve banking as opposed to 100% reserve: http://www.anti-state.com/article.php?article_id=416&PHPSESSID=4c2014f84f6e79664d12b1662eefdce4

I think a system in which depositors understood that there would be situations in which the bank could not withdraw money from their account (as it had been lent out already), would work out alright in a libertarian system. But we do not live under that kind of system. The government has thoroughly fouled up our money, and Gresham's Law ensures that until they change their behavior, better alternatives will not rise up.

Published: July 10, 2006 12:35 AM
Artisan

What would you say is the consequence of the differences between European kind (since 1994) and American central banking? (I’m not talking about the fact that FRB limit in Europe seems to be 2% against 10%(?) in the US or zero in Switzerland… even though you’d think it should affect the profitability of banks, wouldn’t you?)...

I’m speaking about loans given to the government in particular, which are not to be held by the European Central Bank whereas they directly amount 98% of the Fed budget (so much about the Feb getting rid of them when “too much inflation�? happens…).

I suppose as Rothbard mentions(“the Mystery of Banking�?) that “open market purchase�? in the form of corporate bonds eventually have pretty much the same inflationary multiplication effect, as buying government’s bonds? So why might there be such restriction?

Published: July 10, 2006 8:19 AM
Mike Sproul

"if, for sake of argument, we allow that the depositors are aware of the shell game and up for the risk of loosing their money in a foolish gamble, there is still fraud. This is because the borrowers will fraudulently pass their borrowed counterfeit warehouse receipts on to necessarily unsuspecting traders, who are expecting to be paid with real money, not with fraudulent duplicate receipts to other people’s money."

There is nothing foolish about depositing silver in a bank, knowing the bank might pay you back in gold, land, or whatever. We all understand that the world is a risky place, and as I mentioned above, it might well be that a fractional reserve bank is less risky than a 100% reserves bank.

As long as we're conjecturing, suppose that everyone is aware of the nature of the bank's assets, and everyone agrees to accept the notes. Then there would be no fraud even when the notes circulate widely.

Published: July 10, 2006 9:08 AM
Mike Sproul

Artisan:

"I’m speaking about loans given to the government in particular, which are not to be held by the European Central Bank whereas they directly amount 98% of the Fed budget"

On the real bills view, the problem with the central bank (CB) buying the bonds of its own government is partly the fact that the CB can be pressured into accepting bonds that are worth less than the currency issued, and partly the fact that the CB would be backing a dollar with bonds that are themselves denominated in dollars. Thus, when the dollar drops in value, the bonds drop in value too, but since these bonds back the dollar, the dollar falls a little more, etc. This means it's unwise for any CB to buy any assets denominated in its own currency, even though that's just what most of them do.

Published: July 10, 2006 9:22 AM
Thant Tessman

All this talk about whether fractional-reserve banking is theoretically possible under libertarian conditions seems odd to me because I have a book from the twenties about banking and finance that seems to describe exactly that. I don't have it at hand or I'd provide more detail. I think it was published by something called the "Alexander Hamilton Institute."

A bank was certainly free to sell shares (i.e. claims of ownership) in the bank's assets, which included outstanding loans. And people were certainly free to trade these shares. But they never pretended that these shares were guaranteed to be redeemable on demand in specie. The book stated outright that you may or may not be able to find someone to pay you face value for them.

Published: July 10, 2006 9:59 AM
Artisan

Mike sproul:
I’m not sure I quite understand your point. You mean to buy bonds labelled in the own currency to “back the money�? is kind of unwise (on that I agree of course), and yet, everyone does it…
But still, this doesn’t make a difference from buying bonds issued by a private corporate and labelled in the same currency, does it? So that doesn’t answer my question: what is the idea behind that different CB regulation (no government bonds please) in Europe?

Anyways, here’s to the funny arguments I checked on Gene Callahan’s web page in detail:
It seems to me thus the real problem is that FRBanks don’t go broke (they’re backed by government raising taxes). Instead, the private people do.

Published: July 10, 2006 4:35 PM
Al

Thank you, Paul. I'll add that into the discussion.

I'd also like to find out what my friend meant by wildly oscillating inflation.

I haven't studied mainstream Econ enough, but I find it hard to come up with examples of it from my own knowledge of history.

Published: July 10, 2006 9:34 PM
Mike Sproul

Artisan:
"But still, this doesn’t make a difference from buying bonds issued by a private corporate and labelled in the same currency, does it? So that doesn’t answer my question: what is the idea behind that different CB regulation (no government bonds please) in Europe?"

The inflationary feedback I mentioned happens whenever a CB buys anything denominated in its own currency--private bonds included.

The "no government bonds" rule is meant to prevent a repeat of the European hyperinflations of the 1920's, where governments demanded (say) 100 marks from the CB and gave the CB a bond worth considerably less in return.

Published: July 10, 2006 10:44 PM
Paul Edwards

Al,

You're very welcome. I'm flattered that you'd post my responses in your own blog. I took a look and I noticed that someone has responded to one of my points with this (partially):“…Of course it's a con; all societies are. We decide to follow a set of rules so we don't go around slaughtering each other.�?

Since I can easily tell that the libertarian ethic is important to you, it is probably unnecessary for me to point out the internal inconsistency from a libertarian perspective of this poster’s position (is LibertyBob a libertarian?). The impression I get is that the poster is not at all convinced that the libertarian ethic holds any high ground at all over any other ethic that might be preferred by someone else.

In contrast, I would argue that the “set of rules�? we libertarians would propose to abide by do not constitute a “con�? in any sense. They are a completely morally justifiable set of rules based on private property and they make human social cooperation and conflict avoidance possible. Or in other words, we propose the non-aggression axiom as our norm.

The Federal Reserve, on the other hand, and the manner in which it colludes with the banking industry, defrauds consumers through a wealth redistribution via currency debasement and is another story altogether. It most certainly represents a con. It is quite difficult to convey the extent of it without presuming a fair bit of background in Misesian and Rothbardian (Austrian) analysis of money and banking. So I will just say emphatically that it is essential that libertarians obtain a sound grip on Austrian economic theory in order to more easily recognize when libertarian principles are trampled by various aggressive economic and monetary policies of the state.

I think you’ve landed on a good site here at mises.org if further investigation into these topics grabs your interests. There is an abundance of online literature that elaborates in necessary detail not only on banking and money, and not even only economics, but on praxeology in general and how it applies also to the subject of libertarian ethics and what has been termed Austrian Law.

Enjoy!

Published: July 11, 2006 1:50 AM
Artisan

@Mike Sproul.

The "no government bonds" rule is meant to prevent a repeat of the European hyperinflations of the 1920's, where governments demanded (say) 100 marks from the CB and gave the CB a bond worth considerably less in return.

Why would this not happen in the case of corporate bonds open market purchase? European CB is free to buy those. Do you have a source for this assumption by any chance?

Published: July 11, 2006 3:26 AM
Roger M

Al: "I'd also like to find out what my friend meant by wildly oscillating inflation."

He may be talking about the hyperinflation in Germany during the 1920's. But that was caused by a central bank manipulating money. Money inflation, and therefore price inflation, was extremely rare under the gold standard.

Your friend may also be thinking of boom and bust business cycles. Marx accused capitalism of causing these, without any evidence. Most can be explained by government intervention, paper money, or credit expansion due to fractional reserve banking, but not to capitalism. The history of the US Fed proves that their policies have been procyclical, rather than cycle dampening as they were intended.

Published: July 11, 2006 9:06 AM
Mike Sproul

Artisan:

"Why would this not happen in the case of corporate bonds open market purchase? European CB is free to buy those."

Yes; a corporation could also exert undue pressure on the CB to buy its bonds at inflated prices, but the hyperinflations of the 1920's were caused by governments exerting undue pressure on the CB, and all the significant inflations I can think of were also caused by CB's buying government bonds. That's why the prohibition focused on government bonds.

"Do you have a source for this assumption by any chance?"

Not off the top of my head, but you'd probably find some useful info, and lots of sources, by looking up "The Ends of Four Big Inflations" (1981) by Thomas Sargent, (working paper #158 at FRB Minneapolis)

Published: July 11, 2006 12:11 PM
Thant Tessman

Mike Sproul: "Yes; a corporation could also exert undue pressure on the CB to buy its bonds at inflated prices, but the hyperinflations of the 1920's were caused by governments exerting undue pressure on the CB, and all the significant inflations I can think of were also caused by CB's buying government bonds. That's why the prohibition focused on government bonds."
Argh! Central banks exist to finance government spending. Period. That's why they're created. That's why they're granted monopoly privileges by the government itself. Any honest study of history makes this abundantly clear. The Weimar Republic didn't suffer hyperinflation because the government "pressured" the central bank to buy government bonds. Banks want to print money. Normally the markets won't let them get away with it. It's only when the governments do things like arrest people if they dare use foreign currency (as in Weimar Germany) that things like hyperinflation can happen.

Published: July 11, 2006 1:01 PM
Paul Edwards

Is this post too big? This is from De Soto's section labelled "IGNORANCE OF LEGAL ARGUMENTS" in his "MONEY, BANK CREDIT, AND ECONOMIC CYCLES":

Theorists of fractional-reserve banking tend to exclude legal considerations from their analysis. They fail to see that the study of banking issues must be chiefly multidisciplinary, and they overlook the close theoretical and practical connection between the legal and economic aspects of all social processes.

Thus free-banking theorists lose sight of the fact that fractional-reserve banking involves a logical impossibility from a legal standpoint. Indeed at the beginning of this book we explained that any bank loan granted against demand-deposit funds results in the dual availability of the same quantity of money: the same money is accessible to the original depositor and to the borrower who receives the loan. Obviously the same thing cannot be available to two people simultaneously, and to grant the availability of something to a second person while it remains available to the first is to act fraudulently.

Such an act clearly constitutes misappropriation and fraud, offenses committed during at least the early stages in the development of the modern banking system, as we saw in chapter 2.

Once bankers obtained from governments the privilege of operating with a fractional reserve, from the standpoint of positive law this banking method ceased to be a crime, and when citizens act in a system backed in this way by law, we must rule out the possibility of criminal fraud. Nevertheless, as we saw in chapters 1 through 3, this privilege in no way provides the monetary bank-deposit contract with an appropriate legal nature. Quite the opposite is true. In most cases this contract is null and void, due to a discrepancy concerning its cause: depositors view the transaction as a deposit, while bankers view it as a loan. According to general legal principles, whenever the parties involved in an exchange hold conflicting beliefs as to the nature of the contract entered into, the contract is null and void.

Moreover even if depositors and bankers agreed that their transaction amounts to a loan, the legal nature of the monetary bank-deposit contract would be no more appropriate. From an economic perspective, we have seen that it is theoretically impossible for banks to return, under all circumstances, the deposits entrusted to them beyond the amount of reserves they hold. Furthermore this impossibility is aggravated to the extent that fractional-reserve banking itself tends to provoke economic crises and recessions which repetitively endanger banks’ solvency. According to general legal principles, contracts which are impossible to put into practice are also null and void. Only a 100-percent reserve requirement, which would guarantee the return of all deposits at any moment, or the support of a central bank, which would supply all necessary liquidity in times of difficulty, could make such “loan�? contracts (with an agreement for the return of the face value at any time) possible and therefore valid.

The argument that monetary bank-deposit contracts are impossible to honor only periodically and under extreme circumstances cannot redeem the legal nature of the contract either, since fractional-reserve banking constitutes a breach of public order and harms third parties. In fact, because fractional-reserve banking expands loans without the support of real saving, it distorts the productive structure and therefore leads loan recipients, entrepreneurs deceived by the increased flexibility of credit terms, to make ultimately unprofitable investments. With the eruption of the inevitable economic crisis, businessmen are forced to halt and liquidate these investment projects. As a result, a high economic, social, and personal cost must be borne by not only the entrepreneurs “guilty�? of the errors, but also all other economic agents involved in the production process (workers, suppliers, etc.).

Hence we may not argue, as White, Selgin, and others do, that in a free society bankers and their customers should be free to make whatever contractual agreements they deem most appropriate.157 For even an agreement found satisfactory by both parties is invalid if it represents a misuse of law or harms third parties and therefore disrupts the public order. This applies to monetary bank deposits which are held with a fractional reserve and in which, contrary to the norm, both parties are fully aware of the true legal nature and implications of the agreement.

Hans-Hermann Hoppe158 explains that this type of contract is detrimental to third parties in at least three different ways. First, credit expansion increases the money supply and thereby diminishes the purchasing power of the monetary units held by all others with cash balances, individuals whose monetary units thus drop in buying power in relation to the value they would have had in the absence of credit expansion. Second, depositors in general are harmed, since the credit expansion process reduces the probability that, in the absence of a central bank, they will be able to recover all of the monetary units originally deposited; if a central bank exists, depositors are wronged in that, even if they are guaranteed the repayment of their deposits at any time, no one can guarantee they will be repaid in monetary units of undiminished purchasing power. Third, all other borrowers and economic agents are harmed, since the creation of fiduciary credit and
its injection into the economic system jeopardizes the entire credit system and distorts the productive structure, thus increasing the risk that entrepreneurs will launch projects which will fail in the process of their completion and cause untold human suffering when credit expansion ushers in the stage of economic recession.159

In a free-banking system, when the purchasing power of money declines in relation to the value money would have were credit not expanded in a fractional-reserve environment, participants (depositors and, especially, bankers) act to the detriment of third parties. The very definition of money reveals that any manipulation of it, society’s universal medium of exchange, will exert harmful effects on almost all third-party participants throughout the economic system. Therefore it does not matter whether or not depositors, bankers, and borrowers voluntarily reach specific agreements if, through fractional-reserve banking, such agreements influence money and harm the public in general (third parties). Such damage renders the contract null and void, due to its disruption of the public order.160 Economically speaking, the qualitative effects of credit expansion are identical to those of the criminal act of counterfeiting banknotes and coins, an offense covered, for instance, by articles 386–389 of the new Spanish Penal Code.161 Both acts entail the creation of money, the redistribution of income in favor of a few citizens and to the detriment of all others, and the distortion of the productive structure. Nonetheless, from a quantitative standpoint, only credit expansion can increase the money supply at a fast enough pace and on a large enough scale to feed an artificial boom and provoke a recession. In comparison with the credit expansion of fractional-reserve banking and the manipulation of money by governments and central banks, the criminal act of counterfeiting currency is child’s play with practically imperceptible social consequences.

The above legal considerations have not failed to influence White, Selgin, and other modern free-banking theorists, who have proposed, as a last line of defense to guarantee the stability of their system, that “free�? banks establish a “safeguard�? clause on their notes and deposits, a clause to inform customers that the bank may decide at any moment to suspend or postpone the return of deposits or the payment of notes in specie.162 Clearly the introduction of this clause would mean eliminating from the corresponding instruments an important characteristic of money: perfect, i.e., immediate, complete, and never conditional, liquidity. Thus not only would depositors become forced lenders at the will of the banker, but a deposit would become a type of aleatory contract or lottery, in which the possibility of withdrawing the cash deposited would depend on the particular circumstances of each moment. There can be no objection to the voluntary decision of certain parties to enter into such an atypical aleatory contract as that mentioned above. However, even if a “safeguard�? clause were introduced and participants (bankers and their customers) were fully aware of it, to the extent that these individuals and all other economic agents subjectively considered demand deposits and notes to be perfect money substitutes, the clause referred to would only be capable of preventing the immediate suspension of payments or failure of banks in the event of a bank run. It would not prevent all of the recurrent processes of expansion, crisis and recession which are typical of fractional-reserve banking, seriously harm third parties and disrupt the public order. (It does not matter which “option clauses�? are included in contracts, if the general public considers the above instruments to be perfect money substitutes.) Hence, at most, option clauses can protect banks, but not society nor the economic system, from successive stages of credit expansion, boom and recession. Therefore White and Selgin’s last line of defense in no way abolishes the fact that fractional-reserve banking inflicts severe, systematic damage on third parties and disrupts the public order.

Published: July 11, 2006 6:34 PM
Paul Edwards

One more point, from De Soto's "A Critical Note on Fractional-Reserve Free Banking"

https://mises.org/journals/qjae/pdf/qjae1_4_2.pdf :

"Any manipulation of money, which is the generalized means of exchange accepted in society, always implies, in accordance with the very definition of the concept of money, that unidentified third-party participants are affected. We are, of course, not talking about the so-called pecuniary externalities which are transferred in the market through the price system as a result of changes in subjective valuations and in human actions subject to general legal principles. On the contrary, we refer to serious social interferences which originate from the irregular juridical foundation of bank demand-deposit contracts which make possible the anomaly of multiplying the amount of money, regardless of the wishes of the parties, without any saving taking place or anything new having occurred. In fact, economically speaking, the effects of the credit expansion are, from a qualitative point of view, identical to those of the criminal forgery of coins and bank notes which are dealt with, for example, in articles 283-90 of the Spanish Criminal Code. Both of them imply the creation of money, the redistribution of income in favor of a few people to the detriment of the other citizens, and the overall distortion of the productive system. However, from a quantitative point of view, only a credit expansion is able to expand the monetary supply by a sufficient volume and at a rate capable of feeding an artificial boom and causing a recession. In comparison with the credit expansion of fractional-reserve free banking and the monetary manipulation of governments and central banks, the criminal forgery of money is child’s play and almost imperceptible."

Published: July 12, 2006 12:26 PM
Mike Sproul

Paul Edwards:

"we explained that any bank loan granted against demand-deposit funds results in the dual availability of the same quantity of money: the same money is accessible to the original depositor and to the borrower who receives the loan. Obviously the same thing cannot be available to two people simultaneously, and to grant the availability of something to a second person while it remains available to the first is to act fraudulently."

I think this is the crux of your argument. Trouble is that fractional reserve banking does not make the same thing available to two people simultaneously. If paper dollars are backed by silver AND the IOU's (in turn backed by land) then it is as if the silver and the land have both been coined into money. Bankers don't create money without getting collateral in exchange, so every dollar issued must be backed by an exclusive claim by the bank on something of value. In the limit, the maximum amount of money banks will create is equal to the aggregate value of all the goods in the economy that could possibly be offered as collateral. As long as the terms of money issue are agreed to by the banker and his customers, there is no fraud. Furthermore, your contention that fractional reserve banking causes inflation assumes the correctness of the quantity theory--you assume it will cause inflation and is therefore fraudulent. But on real bills principles it will not cause inflation and is therefore not fraudulent on any level.

Published: July 12, 2006 12:38 PM
Paul Edwards

Mike,

That the bank customers both hold title to the same money at the same time, is indeed quite central to the argument of fraud.

But further, we don't see eye to eye on the concept of money, at all. I completely accept the Misesian view. You completely reject it. From there our dispute can only go down-hill. In my view, the depositor and the borrower are both (under the belief that they are) holding titles to ounces of silver (money), not acres of land or bottles of wine. In a free market, only one commodity in a period of history can be money.

Published: July 12, 2006 1:15 PM
Thant Tessman

Paul Edwards: "In a free market, only one commodity in a period of history can be money."

Money is any commodity used to facilitate exchange. In a free market, people tend to gravitate towards the use of one commidity for money because you get the "unit of accounting" benefits that go along with that, but your original statement is too strong.

The real problem with Mike Sproul's line of reasoning is not that IOUs can't or won't be used as money, but that they will automatically be discounted against the thing that they are an IOU for, because they are a future claim, not a present claim. Consequently, (absent of fraud) they won't serve well as assets on top of which even more IOUs can be issued. In other words, there is an automatic and very strong restraint on the ability of the banks to expand the money supply as long as the banks must explicitly distinguish between present and future claims, and as long as they're held accountable to those claims. Competition amongst banks in a free market will impose those restraints, which is why banks have of always looked to government to reduce or eliminate these restraints, which the government does in exchange for financing government debt.

Published: July 12, 2006 2:43 PM
Paul Edwards

Thant,

I think my wording suffers more from being too clumsy rather than from being too strong. Money is the single most marketable commodity.

The Austrian view of money, its purpose, how it emerges and its uniqueness as a commodity with the highest degree of marketability has not been substantially modified since Mises's "Theory of Money and Credit". Even these days, Hoppe still quotes Mises to make the point: "there would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money." and Hoppe states himself, "the competition between monies qua media of exchange inevitably leads to a tendency of converging toward a single money-as the most easily resold and readily accepted commodity."

This competition has happened already. The market decided long ago. Gold was selected. The fundamental problem with Mike's line of reasoning is that it ignores and goes counter to Mises's theory of money. A great deal of Mises must be refuted before Mike can begin to make an argument supporting his position. And i don't expect Mike to be refuting Mises in the near future.

Published: July 12, 2006 4:06 PM
Thant Tessman

Paul,

Hoppe and Mises observe that a free market tends toward the use of a single commodity as money.

Yhis is not the same thing as stating that money is the single most marketable commodity, or that the market has once and for all decided that money is gold.

Any commodity used to facilitate indirect exchange is functioning as money. Some things tend to have properties that make them superiorly suited for use as money. These properties include fungibility, durability, portability, divisability, and demand (independent of its use as money). Collectively, these properties can be described as "remarketability," and under free-market conditions, gold just happens to be really well-suited for use as money.

But we don't live under free-market conditions, and tyrants and charlatans have teamed up to replace gold with magical symbols--magical symbols that they can print up any time they want. They have succeeded.

The problem is that, as in the Weimar Republic, the parasite is in danger of killing its host.

Published: July 12, 2006 11:32 PM
Paul Edwards

Thant,

I’m probably just quibbling, but I’ll throw in my last little bit of two cents worth, as it applies to Mike’s arguments:

“Hoppe and Mises observe that a free market tends toward the use of a single commodity as money.�?

Yes, they are saying that in a free barter market, people tend to start adopting certain specific more marketable commodities and use them for indirect exchange to overcome the problem of non-coincidence of wants. As this process continues and refines itself into a money economy, one and only one single commodity must and will emerge as the sole money. Once an economy lands on this single commodity as money, people will stick with this single commodity as money, presuming a free market prevails; and a free market is the context in which Mike is making his claims.

“This is not the same thing as stating that money is the single most marketable commodity,�?

I don’t understand the basis on which you come to this conclusion, but in any event, I strongly disagree, and I don’t think you can support this claim. But I am open to hearing you try.

“or that the market has once and for all decided that money is gold.�?

Historically, gold has been chosen, and likely would be chosen again, but if you are saying it is not an apodictic certainty that gold be chosen, I agree.

“Any commodity used to facilitate indirect exchange is functioning as money.�?

In the later stages of a barter economy as potential monies, vie so to speak, for the unique status of money, this is correct. But only when the economy settles on a single commodity money, can the economy be considered to be completely monetary. Until then it remains partially barter.

“Some things tend to have properties that make them superiorly suited for use as money. These properties include fungibility, durability, portability, divisability, and demand (independent of its use as money). Collectively, these properties can be described as "remarketability," and under free-market conditions, gold just happens to be really well-suited for use as money.�?

We agree. All I am saying is once this singularly most marketable commodity is chosen by the market, and the market becomes completely monetary, money is chosen. No other commodity will subsequently arise to take its place in a free market.

“But we don't live under free-market conditions, and tyrants and charlatans have teamed up to replace gold with magical symbols--magical symbols that they can print up any time they want. They have succeeded.�?

Yes, and Mike’s vision of equating land and other collateral for loans and debt instruments etc as money is a radical endorsement of this magical, bizarre and fraudulent world where one can justify printing up claims to it and passing it off as money at any time. Even though we live in world of fraudulent fiat currencies, it remains important to remember what true money is, how it is different from non-monetary commodities, how it emerges from barter and why IOUs cannot be honestly construed as money under any circumstances.

“The problem is that, as in the Weimar Republic, the parasite is in danger of killing its host.�?

Yes.

Published: July 13, 2006 12:20 AM
Thant Tessman

I wrote: “This is not the same thing as stating that money is the single most marketable commodity,�?

Paul replies: "I don’t understand the basis on which you come to this conclusion, but in any event, I strongly disagree, and I don’t think you can support this claim. But I am open to hearing you try."

Yes, the single most marketable commodity in a given market is very likely being used as money, but that's not the Austrian definition of money. The existence of a single most marketable commodity doesn't mean that other things aren't simultaneously being used as money in different situations.

Mises uses the notion of the evenly-rotating economy as an intellectual tool to help us understand how markets work. But the main lesson of the evenly-rotating economy is that although economies tend to approach this ideal evenly-rotating state, they never get there because conditions are always changing and information is always imperfect.

The notion of a single money is the same. A free market will tend toward the use of a single commodity as money, but this doesn't mean that there aren't times and situations where other things are used as money, even in a free market.

But these are indeed nits when the topic is central banking.

Published: July 13, 2006 8:25 AM
Paul Edwards

Hi Thant,

“…the main lesson of the evenly-rotating economy is that although economies tend to approach this ideal evenly-rotating state, they never get there because conditions are always changing and information is always imperfect.

“The notion of a single money is the same. A free market will tend toward the use of a single commodity as money, but this doesn't mean that there aren't times and situations where other things are used as money, even in a free market.�?

Now i see where you're coming from. You are right to point out that the ERE is a simplification that allows us to distinguish between what state the economy is constantly moving towards, versus what state it in fact is constantly in. So in that sense, I agree with you, in reality, there is always uncertainty, always speculation and entrepreneurship, and there are profits and loss beyond pure interest etc.

However, i don't think Mises was suggesting that part of this process, in an established monetary economy, that the choice of money itself was also evolving and changing in the same way that values, prices and allocations of resources are always changing. Only in the later stages of a barter economy is there such a possibility for doubt about what commodity is money. In an established monetary economy, there is no further question of what is money and as each moment passes, this money, whatever it is, becomes further entrenched as the sole money.

So I would therefore maintain that in a free market, once a commodity such as gold, for instance, was chosen by the market as money, that baring state aggression and collusion with the banking industry, no transition from gold (for instance), or competition with gold as money is possible.

However, if you can find something in Mises, Rothbard or any of the other many distinguished authors associated with the Mises institute that suggest otherwise, I would be sincerely very interested to take a look at what they have to say about it.

Published: July 13, 2006 1:31 PM
Mike Sproul

"The fundamental problem with Mike's line of reasoning is that it ignores and goes counter to Mises's theory of money. A great deal of Mises must be refuted before Mike can begin to make an argument supporting his position. And i don't expect Mike to be refuting Mises in the near future."

The real bills doctrine also goes completely counter to Henry Thornton, Keynes, Marshall, Wicksell, etc., and I don't have any plans to write a dictionary-sized refutation of any of them. They all started from the view that when paper money is inconvertible, it must be unbacked, and so they set out to explain the puzzle of how an unbacked piece of paper can have value.

The real bills doctrine says that paper money was never unbacked in the first place, and that being inconvertible is not the same thing as being unbacked. Furthermore, there are two kinds of convertibility: physical convertibility, where a dollar is convertible into an ounce of silver, and financial convertibility, where a dollar is convertible into a dollar's worth of the bank's assets. As long as a bank maintains financial convertibility, physical convertibility is irrelevant. For example, after the xmas shopping season ends, people will bring their dollar notes back to the bank wanting silver in exchange, but the bank could head off this demand be selling its assets for paper dollars before the dollars return to the bank, thus heading off the demand for physical convertibility into silver. The dollars can be physically inconvertible, but they are certainly financially convertible, and certainly backed. Hence there was never any "puzzle" for Thornton et. al. to explain, and their monetary theory becomes irrelevant.

And BTW: Who made Mises the god of monetary theory? I'd be hard-pressed to come up with anything he ever said on the subject that had not been endlessly repeated from at least the time of Adam Smith and Thornton.

Published: July 13, 2006 7:13 PM
Paul Edwards

Mike,

“And BTW: Who made Mises the god of monetary theory? I'd be hard-pressed to come up with anything he ever said on the subject that had not been endlessly repeated from at least the time of Adam Smith and Thornton.�?

Didn’t you say you read a little “Theory of Money and Credit�? and decide pretty quickly Mises wasn’t worth reading further?

There are a few things you should know. Firstly, while Mises and the Austrians before him, and those who have followed have in one way or another entirely refuted Keynes and the others whose economics is not soundly based on praxeology, no one, on the other hand, has refuted Mises on his ideas on money and credit.

Therefore, while it is unnecessary for you to refute Keynes, since that has been done already, you will still need to refute Mises, since that has not yet been done already and your theories ignore and are contrary to his insights and conclusions. He’s no god, and some of his ideas have been improved on in certain areas of thought. But the money regression and his ideas on the nature and characteristics of money have not been improved on much to my knowledge and certainly have never been refuted.

The key first step though, in refuting Mises, is to understand his methods and arguments. You still must put in the effort to take this first step before you can pursue the more daunting undertaking of refuting him.

Published: July 14, 2006 2:37 AM
Dennis Sperduto

“And BTW: Who made Mises the god of monetary theory? I'd be hard-pressed to come up with anything he ever said on the subject that had not been endlessly repeated from at least the time of Adam Smith and Thornton.�?

In the Theory of Money and Credit, Mises initiated his project to bring the analysis of money under the framework of subjective, marginal utility analysis. He did not complete this project until 1940 with publication of the German-language predecessor of Human Action. Whatever opinion one holds regarding the correctness of Mises’s monetary framework, his analysis of money, while to some extent in the Austrian School tradition of Menger and Böhm-Bawerk, was largely original and path breaking, and certainly not in the mold of the mainstream economics profession then, now, or at any intervening time.

Published: July 14, 2006 7:53 AM
Mike Sproul

"Didn’t you say you read a little “Theory of Money and Credit�? and decide pretty quickly Mises wasn’t worth reading further?"

I read the whole thing, and even kept the notes I took. Mises certainly deserves credit for refuting Keynes (though Keynes unfortunately came to dominate economics anyway), but Mises' monetary theory was the quantity theory, and thus committed the same errors as Smith, Ricardo, Thornton, Fisher, etc., etc.

Published: July 14, 2006 9:07 AM
Thant Tessman

Paul: "Only in the later stages of a barter economy is there such a possibility for doubt about what commodity is money. In an established monetary economy, there is no further question of what is money and as each moment passes, this money, whatever it is, becomes further entrenched as the sole money."

There is a huge advantage to using as money whatever commodity it is everyone else is also using as money, which is the force which eventually "entrenches" a given commodity as money. But this no more precludes the use of other commodities as money than it precludes barter. Yeah, it's gonna be rare, but it is not apodictically ruled out as it were.

The relevance to Mike Sproul's arguments is that banks can issue, and even have issued claims againt their assets, which included debt owed to them. My understanding was that these shares as a rule weren't used as money--at least not under what were more free-market-like conditions. It took legal tender laws and some banker-friendly court rulings before they got away with that.

As I said, the real problem with his arguments is that the inflationary actions of the banks that he is trying to defend as fundamentally legitimate, although not logically impossible, simply wouldn't happen under genuinely free-market conditions. His arguments, like most of what passes for economics these days, are merely ex post facto apologia for the massive fraud that is fiat currency.

Published: July 15, 2006 5:53 PM
Mike Sroul

Thant:
"the real problem with his arguments is that the inflationary actions of the banks that he is trying to defend as fundamentally legitimate, although not logically impossible, simply wouldn't happen under genuinely free-market conditions."

Of course they would happen, and they have happened, with or without banks. 100-some years ago, it was common for a merchant to accept a customer's IOU for goods sold. The "bill of exchange" as it was called, would trade from hand to hand as money. The bill would promise to pay so many shillings in so many days, and was backed by the collateral of the issuer--i.e., they were issued on fractional reserve principles. It was voluntary trade and as long as the collateral of the issuer was adequate they caused no inflation. The only way one could claim they were fraudulent would be by asserting that their issue was inflationary. But that claim assumes the correctness of the quantity theory--the very point in dispute.

Published: July 15, 2006 6:15 PM
Thant Tessman

I wrote: "the real problem with his arguments is that the inflationary actions of the banks that he is trying to defend as fundamentally legitimate, although not logically impossible, simply wouldn't happen under genuinely free-market conditions."

Mike Sproul: "Of course they would happen, and they have happened, with or without banks. 100-some years ago, it was common for a merchant to accept a customer's IOU for goods sold. The "bill of exchange" as it was called, would trade from hand to hand as money."

No, I meant that, in a free market, no bank would survive long using such an IOU as an asset upon which to pyramid further IOUs. Banks that pulled these kind of tricks found themselves going out of business. Contrary to the mumblings of modern bank apologists, this was a good thing.

Published: July 15, 2006 6:31 PM
Paul Edwards

Thant,

“There is a huge advantage to using as money whatever commodity it is everyone else is also using as money, which is the force which eventually "entrenches" a given commodity as money. But this no more precludes the use of other commodities as money than it precludes barter. Yeah, it's gonna be rare, but it is not apodictically ruled out as it were.�?

Correct. Incorrect. And yes, it is apodictically ruled out. Praxeological analysis shows us that necessarily once the market chooses a money, this precludes any other commodity as money from then on. This might not preclude a barter transaction here and there, but it certainly does preclude the existence of a second money in a single economy.

If two monies could exist side by side in an economy in a free market, even if rarely, then it would certainly be incorrect to state, as Mises does, that the prices of money “cannot be expressed in terms of money�?. According to Mises, the price of money can only be expressed in terms of its purchasing power against any particular vendible good but not against a money price. If you are correct, and the existence of one money doesn’t preclude the use of other commodities as money, then Mises was seriously mistaken to say that one could only talk of money’s purchasing power and not express the price of one money in terms of money.

Mises, Human Action: “Media of exchange have value in exchange. People make sacrifices for their acquisition; they pay "prices" for them. The peculiarity of these prices lies merely in the fact that they cannot be expressed in terms of money. In reference to the vendible goods and services we speak of prices or of money prices. In reference to money we speak of its purchasing power with regard to various vendible goods.�?

Although this seems like a very subtle and tiny and yet still a contentious point, I think it is critically important. It is important because once one recognizes and accepts the very strict and essential praxeological nature of money, as the single most marketable commodity and the solely acceptable commodity as money, and that it is and must be a current good, not a debt, and that paper money is praxeologically and of necessity, a warehouse receipt to this unique commodity money, can the fallacious and fraudulent nature of real bills doctrine and fractional reserve banking be seen clearly for what it is.

Money is a commodity. Money substitutes are legal claims to money at par and on demand. They are warehouse receipts, or titles to money. Banks very simply create multiple claims to the same money and lend them out. They enter into impossible contracts that literally depend on those who they contract with to not all act at the same time in full accordance with these invalid and fraudulent contracts and attempt to redeem their claims. Ultimately, these contracts depend on confusion, misrepresentation and can do nothing but cause trouble and invite government intervention. They cause business cycles, currency devaluations and harm to third parties who hold money yet are not party to these legally impossible and hence void contracts.

A correct Misesian and praxeological view of money necessarily makes plain the conclusion that these banking practices cannot be tolerated by libertarian/Austrian law which must provide protection of private property against fraud and aggression.

Published: July 16, 2006 3:11 AM
Thant Tessman

Paul: "If two monies could exist side by side in an economy in a free market, even if rarely, then it would certainly be incorrect to state, as Mises does, that the prices of money 'cannot be expressed in terms of money.'"

Mises is not incorrect. He's just making a different point.

The use of a commodity as a unit of accounting is a consequence of the use of that commodity as money. It is not what defines that commodity as money. This is the point I think Mises is making, and it's exactly one of the forces which makes an economy tend toward the use of a single commodity as money. If someone decides to use some other commodity as money, they forego the accounting benefits, but that doesn't at all mean it's impossible to use something else as money.

A given economy may have settled on gold as the commodity that it uses as its primary unit of accounting. This doesn't stop someone within that economy from selling their goods or services for silver with no intention of using that silver for anything other than exchanging that silver for yet other goods and services that they intend to consume. In that case, silver is certainly being used as money. And the situation is certainly not that inconceivable.

As for Mises' point, it's merely that the value of money as money can only be expressed in tems of its purchasing power of other goods, not in any formal definition of its use as money. I don't think it had anything to do with the valuation of one money in terms of another in the sense of comparing the price of gold with silver for example.

I was only a child when Nixon came on television to tell us that gold was no longer going to be fixed at $35 dollars an ounce. Even as young as I was, I wondered why the government should be able to tell people that gold had to be $35 dollars an ounce. In my mind, money was dollars. Gold was just something you could buy with it. This is the fallacy I think Mises was addressing in the text you quoted.

If you want to define money as that single most remarketable commodity that is used as the standard unit of accounting within a given economy, then everything you've written is correct. However, I'm not aware that Mises was defining money this way so much as elaborating on its nature. And even if he was defining money this way, we are still left with the fact that people can and do use more than one commodity as a medium of exchange even in a free economy.

As for your point about banks and warehouse receipts, you are of course correct.

Published: July 16, 2006 8:02 AM
Mike Sproul

Thant:

"no bank would survive long using such an IOU as an asset upon which to pyramid further IOUs. Banks that pulled these kind of tricks found themselves going out of business."

Merchant A accepts customer B's IOU, (worth one dollar, and called one dollar) which B deposits in Bank C, receiving 1 checking account dollar in exchange. Bank C then lends B's IOU to customer D, who spends it. The paper dollar is backed by B's assets, and nobody would accept it if they didn't believe B's assets were sufficient. The checking account dollar is initially backed by the bank's assets (which was initially B's IOU). Once the loan is made, B's IOU is replaced on the bank's balance sheet by D's IOU. In the end, the two dollars are backed by B's and D's assets (worth $2), so there is no "pyramiding" and the bank will only go out of business if someone defaults--an ordinary risk of the market
BANK C
ASSETS.....................LIABILITIES
B's IOU worth $1...........1 chk account dollar
-B's IOU worth $1..........
+D's IOU worth $1..........

Published: July 16, 2006 10:45 AM
Thant Tessman

Mike Sproul: "Merchant A accepts customer B's IOU, (worth one dollar, and called one dollar) [...]"

Merchant A would only have accepted customer B's IOU if Merchant A knew customer B personally and trusted them, or at the very least wanted to do them a favor. To anyone else, it would not have been worth one dollar, but would have been discounted from that value based on how unlikely and inconvenient it would have been to redeem that IOU. And none of them would have called it a dollar.

Continuing: "which B deposits in Bank C [...]"

It's unlikely a bank would have accepted the IOU as money under free-market conditions. See above.

Continuing: "receiving 1 checking account dollar in exchange. Bank C then lends B's IOU to customer D, who spends it."

This is the point at which the bank is simultaneously committing fraud and inflating the money supply. Whatever it is B owes in place of the IOU is currently already owned by somebody else (possibly B him/herself). Consequently, at best, the bank note spent by customer D is a future claim on an asset currently owned by somebody else. In practice, it's a fradulent claim on an asset the bank doesn't actually own. The result is that there are now two claims on a given asset being used as money, bidding up prices higher than they would otherwise be.

Going on: "The paper dollar is backed by B's assets, and nobody would accept it if they didn't believe B's assets were sufficient."

In practice, in a free market, people didn't accept it. So the banks teamed up with the government passing legal tender laws to force people to accept it. More than that, they required taxes be paid in the government-favored bank's notes to further create demand for them.

It's the single biggest con job in the history of the world. It has all the sophistication of a parlor trick, yet the banks and the government continue to get away with it...

Published: July 16, 2006 12:05 PM
Mike Sproul

Thant:

A accepts B's IOU because B has sufficient assets to back it. For example, the bank accepts my IOU for $500,000 and places a lien on my house for $500,000. I cannot then just sell the house and run off with the proceeds, since the bank has a lien on the house.

All money is issued to people who offer collateral in exchange, and the money is (non-fraudulently) backed by that collateral.

Benjamin Franklin's "Modest Inquiry..." (www.people.virginia.edu/~rwm3n/webdoc6.html)

does a good job of explaining how paper money emerged in the American colonies, and an equally good job of explaining how the money was backed.

Published: July 16, 2006 1:33 PM
Thant Tessman

Mike Sproul: "A accepts B's IOU because B has sufficient assets to back it. For example, the bank accepts my IOU for $500,000 and places a lien on my house for $500,000. I cannot then just sell the house and run off with the proceeds, since the bank has a lien on the house."

But now you're being deliberately ambiguous. Is the IOU a claim on the house? Or is it a future claim to $500,000 in gold or Fed notes? If the former, then any attempt by the bank to lend it out to anyone else as a claim to money is flat-out fraud. If the latter, then the IOU will trade at a discount. That is, if you found somebody willing to accept the IOU in place of money, they won't accept it at face value.

In practice, with the help of legal tender laws, the bank will lend it out as if it were money. This is fraud. Period.

As for Benjamin Franklin, the United States Constitution makes it pretty clear that not all the founders were as confused (or dishonest) about the nature of money as he was. Not that it seems to have mattered in the long run.

Published: July 16, 2006 2:38 PM

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Look! Up in the Sky! It's An Inflation-Fighting Fed!

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